Recently Pandora filed their S-1, a document which a company files with the SEC as a prelude to selling stock to the public. This filing provides details about the company so that potential investors can make an informed decision about whether to buy shares in Pandora and at what price. There's much to like about Pandora - especially as a music fan, but one must remove emotions and examine the underlying economics to arrive at an accurate business assessment. Tremendous consumer adoption and revenue growth are ultimately overshadowed by the ominous cloud of music royalties looming over Pandora.

Pandora revealed some impressive usage numbers and corporate growth. Eighty million registered users have used the service to stream a whopping 3.9 billion hours of music. According to Pandora they claim to do 2% of all radio listening. Not surprising that their service is available on a wide range of devices and they're cultivating a relationship with car companies like Ford. Two hundred and forty five employees have worked to dramatically increase revenue to $90 million over the last 9 months. That's no small feat.

Apparently Pandora has impressed others because they turned down a suitor who offered hundreds of millions. Buried in the document they disclose that "Party A" made an offer to acquire Pandora for $3.14 per share which equates to about $550 million. The investors who have put more than $120,000,000 into the company believe they'll do better by going public. They're expecting to raise $100 million.

Now for the concerning part: music royalties. In the past, I explained how Pandora cannot be a profitable business due to high royalty rates. In their S-1 Pandora confirms this by stating, "CRB has consistently established royalty rates that would, if paid by us, consume an unsustainable percentage of our revenue." Pandora elaborates by stating that $45 million (half of their revenue) was spent on "content acquisition" which is how they describe music royalties. The vast majority goes to record labels but they also pay BMI 1.75% and SESAC 0.38% of gross revenue. They're currently fighting with ASCAP over how much to pay them.

And the outlook only gets worse. Pandora pays additional fees with each new user they add. That is compounded because rates go up 9% every year meaning their royalty bill will continue to swell even if they didn't add new users. Not explicitly mentioned is that Pandora is currently paying highly discounted rates that are 50% lower than what traditional radio stations who broadcast online must pay. That deal ends in 2015 and it's logical to presume that the introductory rates will not be extended and monies owed to record labels will double over night.

Even where there are glimmers of hope further investigation diminishes it. Pandora received $12 million in subscription revenue but that means less than 1 out of 100 people are willing to pay an annual or monthly fee. For those persons though they must pay 80% higher royalty rates so they actually generate less profit for these users then those who just see ads.

Possible expansion areas are discussed like international, talk and sports. However on the international front other countries have even higher royalties than the US. Talk and sports is a possible growth area, but for now people think of Pandora as a music source.

In 2009, Pandora's CEO proclaimed they were profitable and many news sites like TechCrunch, Mashable, Hypebot, and News.com trumpeted this. I was a lone voice to say that it simply wasn't true. Now we know from their own financial records that in fact they lost $32 million that year.

Leveraging their brand and growth numbers I expect Pandora to successfully raise $100 million. People really do like their service. But the unquenchable thirst for higher royalties of the music companies will continue to squeeze the life out of Pandora making it impossible for them to achieve any sizable profit without a radical shift in the business.